Hi everyone and welcome to part three in this series on note structuring. In part two of this series we discussed, using some common sense guidelines how to qualify your potential borrowers. Now that we have qualified the borrower, we will discuss establishing loan terms that are beneficial for all parties involved.

All too frequently I see notes that have been created it what appears to be desperation, for example zero down payment, very low interest rate or even no interest rate to a borrower with sub 500 or worse credit.  I understand that as banks have tightened lending policies, good borrowers may seem scarce. But believe me, they are out there and if you offer to carry the financing on your home sale they will come out of the woodwork.

So at this point we have confirmed we have a good credit borrower, with a substantial down payment that intends to live in the home. Now let's get down to establishing favorable terms. The terms being the interest rate that will be charged to provide the financing as well as the specific the length of time the financing will be given. Years ago, a thirty year term was the norm when buying a home. In recent years, many sellers following the lead of some banks have been requiring balloon payments in five, three or even as short as one year. As a general rule I would recommend establishing a note term somewhere in the middle of these two extremes.

While there is certainly nothing wrong with creating a thirty year, fully amortized loan for your borrower you will find when you go to sell that loan that because of the long tern nature of the deal the payments out beyond the 10-15 year mark are discounted quite heavily, for the simple reason, they are so many years out into the future. On the other hand, interest only loans and other short term loans that require only one-five years of payments before they mature will typically require the borrower to refinance to make the balloon payment obligation at the end of the loan. More often than not, note investors are a skeptical bunch and will look at very short term deal and buy the monthly payments but will tend to stay away from the balloon, assuming the borrower will not be able to secure the financing to cash them out.  Or, if they are willing to buy into the balloon payment they will look at it as if they will have to extend the loan themselves just to keep the payments rolling in.

As with many things in life, moderation is often best. This also applies to the length of loan terms. A moderate loan term that amortizes the loan, meaning the borrower is regularly and consistently paying down the principal balance is best. Many of the loans I have created on properties I've sold have been done like this, a thirty year amortization with a balloon in ten-fifteen years. With this type of structure there are multiple benefits for you, the borrower and the eventual note buyer. First and foremost, the borrower gets a monthly payment they can afford. Additionally the monthly payments they make are paying down the loan principal and allowing them to build an escalating equity position. Which will in turn, allow them time to have built a substantial equity position in the property and making the likelihood, of them being approved for a refinance loan much greater.

For the note buyer there are some distinct advantages to this type of structure. First they can be fairly confident that the good credit borrower will make a substantial number of monthly payments before a balloon payment comes due. Allowing them time to recoup a greater amount of the funds invested into the note purchase and without the drawback of thinking their money will be out there for twenty or even thirty years. Plus the note buyer's confidence in the borrower's ability to refinance out will be much stronger. And of course, giving the note buyer confidence in the borrower's ability to cash them out when the time comes will result in a higher purchase price for the note seller. The bottom line it will put more money in your pocket at the closing of the note sale.

Now, let's wrap up this discussion with the other big factor that will affect the note purchase price, the interest rate on the note. All too often we talk with note holders that have created loans with interest rates that are well below market rates. I had one gentleman just yesterday, tell me the reason he accepted a 4.5% rate on his note was because he saw that was the rate the local bank was advertising. Another gentleman told me his borrower negotiated him down to a 5% rate, stating "I could get a much lower rate at my bank".   Let me say this in response. Do not fall into this trap! Tell the prospective borrower, "if you want bank rates then go to the bank and cash me out." Chances are they won't take you up on it, knowing they will likely have to pay several thousand dollars in points to get that kind of rate in addition to the fact that their income, job history, source of funds, liabilities, etc...will be scrutinized meticulously. Stick to your guns, the headache and uncertainty associated with traditional bank financing is more often that not a great motivator, allowing you to dictate a more favorable and salable interest rate.

Although I see interest rates that run the gamut, most owner financed transactions average in a range between 7%-10%. I have always written notes on the properties I've sold between 9%-10%. Simply put that is the minimum interest rate I am willing to accept to carry the financing for the borrower. Of course, you will have to let your individual situation be your guide when determining what rate to carry the note. Taking into consideration, the credit of your borrower, the amount of down payment they have and the length of time you will possibly carry the note and your need to sell the property.

Lastly, let's talk briefly about seasoning. In the note business seasoning refers to the length of time the borrower has paid on the note. Most note sellers want to sell their note as quickly as possible after it has been created. The minimum amount of seasoning American Contract Buyers LLC will currently accept is one month. Meaning the property must be closed and you must have received at least one monthly payment prior to us buying the note. With that said one month of seasoning is not optimal and will not result in the best possible or premium pricing. Why is that you ask? Track record, while you may have done everything right when creating the note, the borrower has yet to demonstrate a proven track record of timely payments. If you have the ability to collect the payments for a year or more you will benefit not only from the monthly income but also from a much better note buyout price.

I had hoped to cover proper documentation, record keeping, loan servicing and a few other important areas such as the importance of a title policy. However, we'll have to cover that in a future posting.

Until next time, have a great week.

Damen